Monday, April 18, 2005

Housing, one year on

On June 21st, 2004, Brad DeLong discussed whether or not there was a housing bubble in the US.

Nearly one year later the bubble, if there is one, has yet to pop.

It's worth reading down the thread to see people debating whether current housing prices are really determined by fundamentals or if they are just plain crazy. It's interesting to note some of the wrong ideas folks have, even though their misconceptions are common and understandable.

1) People argue that prices are high in places in NYC, Boston, SF etc. because there is no where left to build. This is false because one can always build upwards. SF can become more like Boston, Boston can become more like NYC, and NYC can become more like, I don't know, Tokyo.

A restriction on higher buildings has nothing to do with "limited quantities of land" and everything to do with regulation.

2) People try to compare rental costs with housing prices on a cash flow basis and look at mortgage rates, insurance costs, closing costs, taxes, deductions, etc. None of this stuff matters. Look, calculating the cash outlays needed for buying a house is a good way to figure out how much house you can afford, but all these supplemental expenses just get factored into the price of the home the instant they were made law.

For example, suppose the government added a $100,000 transaction tax to all home purchases. I can assure you that a $500,000 house would instantly start selling for less.

Since all additional costs are factored into the price of a house, P/E (or sale to income) tells you all you need to know about bubbles.

3) The point on P/Es and interest rates is more interesting and difficult to keep straight. On the one hand, whether or not Amazon.com is a bad buy at $100 a share does not depend on how favorable your broker's financing terms are. On the other hand, since purchase price is the net present value of discounted cash flows, lower real interst rates mean that future payments are worth more than they are today so the price (and hence, price to earnings) will and should be higher than historical norms. But I don't know if there is a good reason to beleive that real interest rates are lower today than they have been in the past.